In 1996, Thomas Friedman, the New York Times columnist, remarked on “The NewsHour With Jim Lehrer” that there were two superpowers in the world — the United States and Moody’s bond-rating service

Essentially in their quest for profits, the agencies’ relationship with Wall Street changed from a mysterious and powerful ratings entity to a firm working closely with their clients.

Rating agencies (Moody’s, S&P, Fitch are the biggies) sought fees from investment banks to rate securities. If the ratings were too conservative, the bank could simply go to one of the other agencies to get the rating they wanted to. The agencies were essentially behind the curve in understanding the sophisticated new products being introduced at a rapid rate.

A few years ago, as I was getting more and more frustrated at the lack of neutrality in the mortgage lending process and the shaft given to good appraisers in the form of pressure, even an outsider like me could see that something was wrong with the relationship. The system can’t allow a ratings agency to be at the mercy of fee driven investment banks. The proverbial hand in the cookie jar.

Rating agencies were the enabler of securitization much like appraisers were the enabler of shady lending practices. Search hard enough and long enough and anyone can find someone to make the deal work.

By providing the mortgage industry with an entree to Wall Street, the agencies also transformed what had been among the sleepiest corners of finance. No longer did mortgage banks have to wait 10 or 20 or 30 years to get their money back from homeowners. Now they sold their loans into securitized pools and — their capital thus replenished — wrote new loans at a much quicker pace.

Mortgage volume surged; in 2006, it topped $2.5 trillion. Also, many more mortgages were issued to risky subprime borrowers. Almost all of those subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street.

The search for new profits and their close relationship with Wall Street placed them in a non-neutral position yet investors were relying on the ratings.

Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody’s and Standard & Poor’s that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.

The agencies have a very big credibility problem right now with investors. It’s all about the lack of activity in the credit markets right now.

The credit markets are currently frozen because of the lack of neutrality in the rating and mortgage process, not because investors are ignorant. Next thing we will start hearing is that the agencies and associations will simply self-police.

2 Responses to “[AAA] Ratings Agencies And The New Culture Of Partnership”

Thanks for the reference to the Times article. I understand more of how mortgage money is churned than I did, but I have miles to go. Too bad the author stuck in a reference to inflated appraisals. The implication is that appraisals had some significance in the ratings agencies’ decisions. I just don’t buy that, and the author admitted elsewhere in the article that the agencies didn’t even read the spreadsheets they were provided, indeed there was insufficient time alloted for them to do so even if they had wanted to. That thinking is rabidly popular, mostly because those with fingers that must point can put a mostly defenseless individual’s name on the appraisal. I just don’t believe real estate appraisals, inflated or otherwise, had much impact on the magnitude of this current situation.

No doubt there are appraisers malfunctioning, but this thing is way,way beyond the league of the real estate appraisers.

I don’t think it is the combination of this. Conduits that raised money had a bigger rep for pressuring appraisers than mortgage brokers did (that is my opinion although we had no direct experience with conduits). The entire lending culture was based on moving product with no relation to risk. Did appraisers cause this or were they victims of pressure? Everyone connected with the lending process had a hand in this – it was systemic. Were there appraisers who didn’t play ball to their own detriment? Yes there were but I think it was the exception not the rule.

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About Jonathan Miller

Jonathan Miller is President and CEO of Miller Samuel Inc., a real estate appraisal and consulting firm he co-founded in 1986. He is a state-certified real estate appraiser in New York and Connecticut, performing court testimony as an expert witness in various local, state and federal courts. He holds the Counselors of Real Estate (CRE) and Certified Relocation Professional (CRP) designations. He is an Appraiser “A” Member of the Real Estate Board of New York and a member of Relocation Appraisers and Consultants, Inc.Learn More...

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Matrix Blog

An earlier version of this post appeared in my weekly Housing Notes, March 15, 2019 edition. I’ve since added more information and insights as the situation unfolds. This proposed “pied-a-terre” tax law has a name that infers it concerns “pied-a-terres”… Read More